New Evidence of Government Induced Risk

A year ago I wrote Getting Off Track one of the first books on the financial crisis. I argued, based on data available at the time, that government actions caused, prolonged and worsened the crisis. After a year of debate, this early assessment is holding up well. Indeed it is being reinforced by new evidence.

Consider, for example, the government actions associated with the takeover of Fannie Mae (FNM) and Freddie Mac (FRE) in 2008. Of course, Fannie and Freddie were a big part of the reason for the explosion in mortgage debt including risky subprime mortgages, but I want to focus now on the impact of government actions relating to these institutions during the period leading up to the panic in 2008.

A good way to assess this impact on risks is to look at the spread between interest rates on subordinated debt and senior debt at Fannie or Freddie. When investor concerns about risks at the institutions increase, the interest rate spread between subordinated and senior debt rises. So what caused the movements in these spreads in 2008?

The three charts show the spread between the interest rate on Fannie Mae subordinated debt and Fannie Mae senior debt over three different periods. The yellow line with the green shading in the lower panel of each chart is the interest rate spread of sub debt over senior debt. In the top panel (harder to read) the orange line is the rate on subordinated debt and the white line is the rate on senior debt. The first chart focuses on the period from June 2004 to February 2008. The spread was fairly stable fluctuating in a rather narrow range around 20 basis points over this period.

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The second chart covers the period from March 2008 through June 2008. Observe that the spread jumped to around 80 basis points after the Bear Stearns intervention. Unlike many other risk spreads it did not come back down after Bear Stearns.

(click to enlarge)

The third chart focuses on the period from July 2008 through September 2008. There are two big upward jumps during this period. The first was on July 11. What was the big event that day? It was a leaked news story about a possible government action, a takeover of the two institutions. In particular the New York Times ran a front page story with the headline “U.S. Weighs Takeover of Two Mortgage Giants”

(click to enlarge)

The other big jump up was on Monday August 18th. Again the reason was a news story about another government action. The previous Friday the Washington Post reported that the Treasury hired Morgan Stanley to assess the vulnerability of Fannie and Freddie, a strong indicator that the government was looking for outside justification to take over the institutions. It is important to note also that certain other events, which could have moved the spread up, did not move it up. When Freddie and Fannie released their second quarter earnings in August, there was little to no reaction in the spread.

So the major movements are clearly linked to government policy decisions and news stories about them. This timing does not prove that the government actions were responsible, but at the least it raises questions about why rumors of possible government actions were leaked to the news media.

The questions are important because some government officials have indicated that these jumps in the subortinated debt spread were part of the evidence to justify the take over the institutions at this time. But the evidence shows that the government itself was increasing the spreads.

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of
Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is
currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.